Zawya – Saudi’s MSCI upgrade could attract up to $45 billion but what does it mean for the wider GCC markets?

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Global index provider MSCI said on Wednesday it will reclassify Saudi Arabia as an emerging market from the middle of 2019, a decision which is expected to support the kingdom’s equity market and broaden its investor base.

The move comes ahead of the widely anticipated listing of Saudi energy giant Aramco, in what is expected to be the world’s biggest initial public offering (IPO), which could raise a record $100 billion by selling a 5 percent stake in the firm.

“The inclusion of Saudi Arabia into FTSE Russel and MSCI Indices is expected to generate a foreign institutional investment (FII) of $14 billion in next two years,” Vijay Valecha, chief market analyst at Dubai-based Century Financial Brokers, told Zawya by email, adding that he expects the full impact of MSCI inclusion to be felt in two years.

There will be a two-step inclusion process for Saudi Arabia in May and August next year and the MSCI Saudi Arabia Index will have a weighting of approximately 2.6 percent in the emerging markets index with 32 securities.

“If foreign ownership level reaches the level of its regional peers, the inflows could even top $30 billion,” Valecha said. “That is for sure going to create a liquidity driven rally.”

Investment bank EFG Hermes was even more optimistic and said it expects Saudi Arabia to see $30-45 billion of portfolio inflows in the next two years if it reaches the same level of foreign ownership in equity markets as the United Arab Emirates and Qatar.

Regional spillover

Even though, in the short-term, there could be fund outflow from regional equities to Saudi Arabia, overall Middle East equities are likely to benefit from positive sentiment towards the region, Valecha notes.

“The inclusion of the Saudi market to the global index points to the maturity of the Saudi capital market primarily with regards to efficiency, governance, and regulatory framework,” he said.

“We can say with conviction that this inclusion will provide an impetus for further integration of the kingdom with global economy,” he added.

The positive decision by MSCI regarding Saudi Arabia is transformative for the Middle East as an investment destination, according to Dan Salter, head of equity strategy and research – Eurasia at Renaissance Capital, an emerging and frontier markets investment bank.

So far, only the UAE and Qatar are included in the MSCI Emerging Markets index, in a transition which took place in May 2014.

“These two markets are relatively small, around 0.7 percent of MSCI Emerging Markets each. And our data suggests that international active equity funds benchmarked to MSCI Emerging Markets have in many cases tended to ignore them: positioning data shows a large consensus underweight for both,” Salter told Zawya by email.

With Saudi Arabia included, the Gulf Cooperation Council’s index weight would become 4 percent, he said and “investors tell us this will make the GCC too big to ignore”.

Benchmarks of the global index provider are widely used and around $14 trillion in investors’ assets are tracked against them.

Fast-paced reforms

Data suggests that approximately $3 billion in foreign flows have come into the Saudi equities in 2018, bringing the total foreign investment in the stock exchange to $9 billion, according to Valecha.

“The potential is large as Saudi Arabia has a deep financial market with a total market capitalization of almost $524 billion,” he said

“For example, Global petrochemical giant SABIC has market capitalisation of more than $100 billion. The presence of such large petrochemical and financial sector institutions is likely to perk up interest in Saudi equities,” he added.

The Saudi index has been among the best performing in the Gulf region, up 13.3 percent year to date, according to Reuters.

“Having studied the inclusion of 21 different countries into MSCI Emerging Markets since 1990, our work suggests that, on average, equity markets tend to outperform in the run up to inclusion in MSCI Emerging Markets,” Salter said.

MSCI inclusion of Saudi Arabia has happened at a relatively fast pace, with the strong push from policy makers, Valecha notes.

Saudi Arabia opened up its capital markets to foreign investment in June, 2015, and since then it has worked closely with MSCI to implement the necessary reforms. Many of these reforms, such as the introduction of T+2 settlement (where trades are settled within two working days of execution) and securities borrowing and lending, have enhanced the ease of trading to a great extent and have created new opportunities for market participants.

The adoption of the Global Industry Classification Standard (GICS) last year also enabled the comparability of corporates across markets and resulted in better analysis of sector performance.

But though the QFI (Qualified Foreign Investor) system has been simplified, it is still an administrative hurdle for international investors to get set up in Saudi Arabia, according to Salter.

“As Saudi Arabian companies get more familiar with regular communication with foreign investor, we would expect corporate communication with international investors to become more polished, a process we have seen in many other emerging markets,” he said.

According to Renaissance Capital, Saudi Arabia has the fastest expected growth acceleration of any economy in MSCI EM in 2018. But the market is still not well owned by international investors: Non-GCC portfolio investors own just 1.4 percent of the Tadawul market capitalisation, or around $6 billion, a figure which could be boosted significantly by MSCI EM index inclusion.